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Abstract
Financialisation has been represented as a recent phenomenon linked to the deregulation and
globalization of the international trade and payments system that has been in progress since the opening
of the Chinese economy in the 1980s. It is often represented as the dominance of finance over
production or of monetary over real variables. This essay challenges the usefulness of this dichotomy,
arguing in the tradition of Keynes, Schumpeter and Minsky that it is impossible to separate the financing
of production into separate categories since a production decision always requires finance to be
implemented. It instead suggests that it is the process of innovation in the creation of liquidity by the
financial system that provides a more insightful analysis of the implications of financialisation.
Keywords: Financialization; Minsky, Hyman, 1919-1996; Financial crisis; Liquidity; Ponzi, C. 1882-
1949.
Resumo
“Ismos” e “Zações”: sobre a liquidez fictícia e a financeirização endógena
A financeirização tem sido representada como um fenômeno recente ligado à desregulação e à
globalização do comércio internacional e do sistema de pagamentos que tem ocorrido desde a abertura
da economia chinesa na década de 1980. Esse fenômeno é geralmente definido como a dominação das
finanças sobre a produção ou do monetário sobre as variáveis reais. Este artigo questiona a utilidade
desta dicotomia, argumentando na tradição de Keynes, Schumpeter e Minsky, que as finanças e a
produção são categorias que não podem ser separadas, já que uma decisão de produção sempre requer
a presença das finanças (ou seja, de financiamento) para se concretizar. Em contrapartida, sugere-se
que o processo de inovação na criação de liquidez pelo sistema financeiro fornece uma análise mais
profunda das implicações da financeirização.
Palavras-chave: Financeirização; Minsky; Crise financeira; Liquidez; Ponzi.
JEL G32.
Article received on February 10, 2017 and approved on September 18, 2017.
**
Director of Research at the Levy Economics Institute, Annandale-On-Hudson, NY, USA. E-mail:
kregel@levy.org.
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“Isms” and “Zations”: on fictitious liquidity and endogenous financialization
period of financialisation had its own characteristics and effects. The most common
characteristic is the rapid expansion of financial institutions and financial markets.
In the recent period, the growth in the relative importance of financial markets has
been driven by the rapid expansion in the range and trading turnover of financial
assets such as derivatives and securitization and the rapid rise in the ratio of financial
assets to GDP and financial liabilities to GDP. An enabling feature has been the
deregulation and liberalisation of financial markets and institutions. Mainstream
economics and finance theories have also promoted financial liberalisation by
representing regulation as ‘financial repression’ constraining the ability of the
market to efficiently intermediate saving to support investment. At a systemic level,
financialisation represents the dominance of finance over industry, or in Keynes’s
terms, speculation over enterprise that has driven many nonfinancial corporations to
seek profitability from their financial as opposed to their productive activities”
(Fessud, 2016).
A more analytical explanation builds on the business response to the profit
squeeze of the 1970s and the impact of the petroleum crisis generated by the Arab-
Israeli war. In response to the crisis, policies were implemented to depress wages in
order to offset terms of trade losses imposed by the rise in oil prices; wage bargaining
to keep the growth of nominal wages below the rate of productivity growth. These
two factors operated to depress domestic demand, and instead of the expected
response of an increase in profit-led investment driving growth, the ensuing
stagnation was offset by expansionary monetary policies that generated a series of
financial bubbles, first in real estate in the 1980s and then in the form of the dot-com
boom in the 1990s. It culminated in the recovery of consumer spending even in the
absence of real wage growth with the pass through of rising residential housing
prices to consumer debt-led financing of demand. In this scenario, the inflation of
the 1970s disappears, only to be replaced by asset price inflation, and spurious
growth driven by capital gains, punctuated by periodic crises as the bubbles
collapsed. In this explanation, financial manipulation of asset prices to generate
demand replaces real wage growth as the driver of the economy and the consequent
repetitive financial crises.
There is a variation on this theme that characterizes this process as one in
which manufacturing firms, seeking to augment their profits on manufacturing
activities, turned their treasury functions into profit centers; the Chief Financial
Officer became responsible for adding to bottom line profits through innovative
management of the company finances, and then to engaging in outright speculation
in financial markets. The best-known example of this scenario is the financing of
Hallmark cards and Procter and Gamble at below benchmark market interest rates
through the use of structured financial instruments. Bankers offered financing in
which the firms effectively wrote derivative contracts on interest rates. When Alan
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“Isms” and “Zations”: on fictitious liquidity and endogenous financialization
(1) “The material welfare of the community is unreservedly bound up with the due working of this industrial
system, and therefore with its unreserved control by the engineers, who alone are competent to manage it. To do
their work as it should be done these men of the industrial general staff must have a free hand, unhampered by
commercial considerations and reservations; for the production of the goods and services needed by the community
they neither need nor are they in any degree benefited by any supervision or interference from the side of the owners.
Yet the absentee owners, now represented, in effect, by the syndicated investment bankers, continue to control the
industrial experts and limit their discretion, arbitrarily, for their own commercial gain, regardless of the needs of the
community” (Veblen’s. The engineers and the price system, p. 69-70. Available from:
https://archive.org/details/engineersandpri01veblgoog.
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could happen to the solvency of any financial institution is a forced sale of its assets
in order to acquire cash. Imagine what would happen to asset values, if there were a
need to liquidate government bond positions by the government bond dealers or if
the sales finance companies were suddenly to try to sell their portfolios of consumer
installment paper on some market. In order to prevent this type of forced liquidation
of assets, the financial intermediaries protect themselves by having alternative
financing sources, i.e., by having ‘de facto’ lenders of last resort. These de facto
lenders of last resort ultimately must have access to the Federal Reserve System in
times of potential crisis” (Minsky, 1964, p. 376).
This is the basis of the recognition of competitive innovation in providing
for what I have called “fictitious liquidity” created by shadow banks (Levy Institute,
2012). Thus, there is an alternative explanation of financialization: When the
creation of liquidity exceeds the requirements of the real economy to absorb it in
productive investments then competition will inevitably lead to the creation and
innovation of financial assets which offer the possibility of price appreciation and
thus higher returns than investing in industry. This understanding of financialization
is a profit-driven competitive-innovative process of creation of fictitious liquidity.
Our understanding of this process of excessive and innovative liquidity creation is
clearly historical, and it is on this basis that leads to the dating of the expansion of
financialization at the end of the 1980s as the US and global economy emerges from
the inflationary recession that accompanied the oil crisis of 1973.
The response to these events has been crucial for the subsequent evolution
of the global economy – indeed monetarism is the child of this period, as is the
pressure for increased competition and liberalization in financial markets. This, in
its turn, was a major source of the ability of financial institutions to create unlimited
liquidity to meet the rising demand for liquidity in the period. This approach only
differs in perspective to the use of the term “fictitious capital” used by Guttmann in
his previously cited description of the period – the only difference is his emphasis
on the fictitious capital financed by the fictitious liquidity. Here it is the fictitious
liquidity that led to what we now call financialization. Just as Schumpeter recognized
the importance of banks’ ability to create purchasing power ab nihilo to fund
investment as the source of economic development, it is here argued that the ability
of the financial system to create fictitious liquidity ab nihilo led to the appropriation
and destruction of shareholder value for industrial corporations and the decline in
real investment.
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However, the ability to raise capital requires meeting market returns, which
in turn generates pressure to increase leverage. It is a basic rule of financial markets,
that they are driven by spreads and fees which are maximized by scale, which means
maximizing leverage. By the time of the commercial bank deregulation, most
regulated commercial banks had lost their ability to service corporate clients’
transactions requirements and were limited in their ability to provide capital market
services, which meant that brokers/dealers, investment banks, hedge funds and
others had free reign in dealing with corporations. And they set about rapidly
engineering a merger mania.
Minsky has provided a very neat explanation of this process. Noting that the
return on bank capital will be driven by the net return on its assets multiplied by its
leverage: ROE = ROA * Leverage. We can thus engage in a very simple exercise.
Presume that ROE on bank equity given by the market or by management seeking
to maximize shareholder value or the value of their option linked remuneration is 25
per cent per annum and the return on assets is 5 per cent. Then leverage will be 5
which means that the bank must multiply its asset book by 5. Where are these assets
to come from? If we are to avoid financialization, then investment as a share of GDP
must be sufficient to provide the required growth of assets. What if it does not do
so? Then institutions will seek alternative means of expanding their assets – in the
form of increasing their positions in financial assets – financialization. Now,
introduce the ability of banks to increase their ROE by means of innovation in
liquidity creation, so that leverage becomes an endogenous variable in the equation.
Again, the outcome will be an increase in layering that we call financialization. Thus,
this is the analytical framework – during the 1980s, structural changes occurred
which allowed for substantial increases in both bank and non-bank leverage which
created fictitious liquidity which expanded at a rate far in excess of the financing
needs of the productive sector of the economy. The increased lending via a Ponzi
scheme was needed to generate the capital gains necessary to create the required
returns – until the rate of expansion of liquidity stopped, and crisis intervened.
Compare the financial history of the period with this analytical framework.
The recovery from the OPEC induced inflation and poor profitability of the 1970s
was reversed in the 1980s as the stock market recovered and then boomed under
Reagan supply side policies creating another form of fictitious liquidity – booming
share prices provided liquidity for firms to use no-cash takeovers by using
accelerating stock prices as collateral or direct funding. Thus “a new type of takeover
activity emerged as the leading force in the merger-driven stock market boom, the
hostile takeover bids by so-called corporate raiders” (Guttmann, p. 307). For the
investment banks this was a quadruple opportunity, serving as advisers to the
corporates, providing funding to the acquirers and the opportunity to set up risk
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arbitrage desks to speculate on the outcome of the acquisition and finally doing the
underwriting for taking the company public.
Finally, the beginning of the 1980s saw the development of derivatives
markets which were widely used in products such as portfolio insurance, index
arbitrage and interest rate management. However, as important as these activities
were in generating revenue their importance was mainly due to the massive leverage
they introduced into the system allowing purchasers to take long positions as much
as 20 times the initial margin.
The best example of this period is the operation of Michael Milken at Drexel,
Burnham. Milken discovered and popularized the idea that the risks in non-
investment grade debt (in particular “fallen angels” i.e. companies that had been
recently downgraded) was over-priced, i.e. their prices were lower and their returns
higher than justified by their default performance) suggesting an arbitrage
opportunity for money managers to increase their returns without increasing risks.2
But what was a very sensible idea was eventually converted into an illegal shadow
banking operation in which Milken offered to issue new junk bonds to finance hostile
takeovers, ensuring the sale of the bonds by alerting risk arbitragers and money
managers with inside information on the impending takeover bid, allowing them to
profit by buying before the bid in exchange for a commitment to purchase the junk
bonds, thereby ensuring the success of the bid.
It is operations such as these that represent the beginning of the massive
expansion of liquidity creation outside the regulated banking sector, with no
effective limit, requiring a market return to justify its existence. And institutional
investors together with the newly capitalized financial institutions found ways to
employ their virtually unlimited ability to expand liquidity by the creation of
additional leverage. It is not necessary to recount the entire experience of the 1980s,
which is done very well by Guttmann, nor the subsequent “dot-com” boom which
was fueled in a similar way, or the sub-prime crisis of the 2000s. They all have the
same characteristics in the ability of financial institutions to create fictitious liquidity
to produce fictitious capital. It was the ability to create unlimited liquidity that made
financialization inevitable.
Building on the early work of Robin Marris (Marris, 1964) and others on
managerial capitalism, the stock market was no longer viewed as simply providing
(2) See Kornbluth for a more extensive discussion of Milken’s research on junk bonds which subsequent
to his advocacy came to be called “High Yield” assets. He notes that “At Berkeley in 1967, Milken had an insight
that would, in time, support an entire firm, overthrow conventional wisdom, and put a great many outsiders in
executive offices – the bond services’ seal of approval was less than accurate. All Moody’s and Standard and Poor
seemed to factor into a company’s rating was its past performance, as reflected by the ratio of debt to equity on its
balance sheet. The rating services didn’t seem to care much about cash flow, which as Milken saw it, said everything
about a company’s ability to service its debt” (Kornbluth, 1992, p. 41). This was very similar to Minsky’s approach.
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the liquidity Keynes suggested was required to allow individual investors to hold
illiquid stocks in the belief that they could always be sold. Instead it became the
market for the trade and evaluation of corporations; mergers and acquisitions
imposed market discipline on companies that were performing below market
benchmarks. The idea was that inefficient managers would lose their jobs and new
ones would come in and eliminate inefficiencies. If the takeovers led to increasing
debt ratios, this was positive because the threat of default and the need to meet high
interest burdens led to cost cutting and to labor shedding to raise profitability.
Instead a process started that was closer to what in the UK was called “asset
stripping”. A corporation holding a large cash reserve was a target for takeover; it
could be taken over by using the debt created by a financial institution, the acquired
company would then issue its own debt to repay the acquirers debt and the available
cash transferred to the acquirer, leaving the corporation with an unsustainable debt
service burden, often leading to bankruptcy proceedings. This process was initially
called “value extraction”, and did little to improve corporate efficiency and usually
led to unsustainable debt burdens that required sharp reductions in operations and
loss of employment. In those cases where insolvency was avoided, the corporation
could be resold to shareholders via a public offering which generated additional
funds for the private owners. As managements were displaced by the acquirers, who
came to be called “corporate raiders”, they sought defenses in the form of “poison
pills”, the creation of golden parachutes for managements which, if implemented on
a successful takeover, would generate payments that would leave the company with
no assets, or the issue of massive amounts of debt on the rumor of a takeover in order
to make further issue of debt by the acquirer to fund the acquisition unprofitable.
Usually, shareholders were offered prices to sell their shares in the takeover at a
substantial multiple of the pre-acquisition market price, while management were
offered golden parachutes, in what came to be called “greenmail”.
Eventually managements resolved the threat to their tenure by convincing
shareholders that they were best off by keeping management in place. Thus,
managers argued in favor of compensation supplemented by options linked to the
share price performance to align the objectives of the principals and the agents. This
was presented as a form of operating in the interests of maximizing shareholder value
– but it led to the same results as the corporate raiders, only now it was in the interests
of the management and equity holders to maximize leverage and reduce employment
levels.3 Thus, the advent of private equity fueled by Milken’s liquidity led to a basic
shift in managerial strategy. For example, after the first takeover threat "the Business
Roundtable – an association of 200 CEOs who form a kind of corporate version of
the College of Cardinals, noted in its 1981 Statement of Corporate Responsibility
that a corporation ‘must be a thoughtful institution which rises above the bottom line,
(3) Much of this experience is recounted in Guttmann’s more recent book Finance-Led Capitalism
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to consider the impact of its actions on all, from shareholders to the society at large.’
In other words: Don't judge us on our quarterly earnings, because management –
“which doesn't own much of its own stock – isn't going to do anything to drive the
stock price up just to satisfy shareholders we've never met." (quoted in Kornbluth,
1992, p. 85). This changed radically after options linked to stock price became the
major component of managerial compensation and any and all measures to boost
stock prices were implemented in the name of “maximizing shareholder value”.
Conclusion
In conclusion, we should not be surprised by financialization since it is the
natural result of competition and innovation in which liquidity is allowed to be
determined by the market; the result of an obsessive concentration of monetary
policy on the control of money to stop inflation rather than liquidity that drives the
creation of fictitious liquidity that funds fictitious capital which periodically is
destroyed via financial crisis.
References
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HOLMSTROM, Bengt; KAPLAN, Steven. Corporate governance and Merger
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8220, April, 2001
KORNBLUTH, Jesse, Highly Confident, The Crime and Punishment of Michael
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MARRIS, R., The Economic Theory of Managerial Capitalism, London: Macmillan,
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